The history of coffee goes at least as far back as the thirteenth century with a number of myths surrounding its first use. The original native population of coffee is thought to have come from East Africa, and it was first cultivated by Arabs from the 14th century. The earliest credible evidence of either coffee drinking or knowledge of the coffee tree appears in the middle of the 15th century, in the Sufi monasteries of Yemen. By the 16th century, it had reached the rest of the Middle East, Persia, Turkey and northern Africa. Coffee then spread to Balkans, Italy and to the rest of Europe, to Indonesia and then to the Americas.[3 ow are coffee prices currently set?
A: Coffee prices are set according to the New York “C” Contract market. The price of coffee fluctuates wildly in this speculative economy, generally hovering around fifty cents per pound. Most coffee is traded by speculators in New York, who trade approximately 8-10 times the amount of actual coffee produced each year. The single most influential factor in world coffee prices is the weather in Brazil. Droughts and frosts portend shortages of coffee and the price increases. Specialty coffee is often imported at a negotiated price over the C market, which is considered a ‘quality premium’. Most of those premiums never reach the coffee farmer, but rather stay in the hands of the exporter. This creates a disincentive for farmers to increase their quality, as they do not receive the direct benefits of increased investment in producing better coffee.
Dynamics ofWorld Coffee Prices
The indicator Price system established in 1965 by International Coffee Organization (ICO) to provide a consistent and reliable procedure for reporting prices of different types of coffee. The ICO indicator price system is based on the four spate price groups namely, Colombian mild arabicas, Other mild arabicas, Brazilian and other natural arabicas and Robustas. ICO composite indicator provides a benchmark for price of green coffee. ICO organization collects ex-dock shipment prices data and calculates arithmetic mean. This represents ICO composite indicator. The current ICO composite price (US cents per pound) as listed for March, 2013 is 131.38 cents per pound with a high of 135.30 and low of 128.52 cents per pound.
The dynamics/trend of the monthly ICO composite price over 1998-2012 can be broken down into three phases. (Refer Figure 1 in appendix)
Phase 1: The average composite price for coffee decreases from $108.95 in 1998 to $45.59 in 2001.
Phase 2 begin with an increasing trend line where in average composite price increases from to 47.74 in 2002 and continues the upward swing, hitting the maximum in 2011 at an average composite price of $210.39.
Phase 3 starts the decline in 2012 to an average price of $156.34 from 210.39 in 2011 and continues in 2013 where the current average price for the first three months is $131.38.
Price-elasticity of Demand For and Supply of Coffee
The price elasticity demand is measure to show the elasticity of the quantity demanded of the good or service to a change in its price. IN case of Coffee, Coffee is produced primarily in south american countries and some developing countries but consumed in developed countries.With disruptive weather the supply of coffee is suppressed and hence the price of coffee will rise hence the Price of coffee can be considered volatile. Factors/events that affected the world supply and demand of coffee in 2011-2012. Weather has been rated as one of the top factors affecting the supply of coffee. The countries where coffee is grown is generally humid, disruptive patterns in the weather has caused coffee plant diseases. Some articles have also listed fungus as one of the elements causing decrease in the coffee supplies. Difficulty in growing Arabica plants was also listed as one of the reason for shrinking coffee production. Whereas some positive factors which caused marginal increase in coffee supplies are adding of new producing countries, investment in advanced technologies and increased in number of coffee producers within the same region.
Increase in demand can be associated with emerging new markets such as China which was primarily tea market has now seen a sudden shift in taste. Increase in expendable income due to higher salaries has caused the demand for finer coffee to grow. Major determinants of world coffee prices in 2011-2012
Weather and climate change affect coffee prices more than other factors. Coffee trees require specific climatic conditions to produce an optimum crop. Hence, the Prices remained in high throughout 2011where the average composite price was around $210.
2.4) Porters Five Forces Analysis of the Retail Coffee and Snacks Industry: Threat of New Entrants: Moderate
There is a moderate threat of new entrants into the industry as the barriers to entry are not high enough to discourage new competitors to enter the market. (Appendix 2 shows Barriers to Entry Checklist). The industry’s saturation is moderately high with a monopolistic competition structure. For new entrants, the initial investment is not significant as they can lease stores, equipment etc. at a moderate level of investment.
At a localized level, small coffee shops can compete with the likes of Starbucks and Dunkin Brands because there are no switching costs for the consumers. Even thought it’s a competitive industry, the possibility of new entrants to be successful in the industry is moderate.
But this relatively easy entry into the market is usually countered by large incumbent brands identities like Starbucks who have achieved economies of scale by lowering cost, improved efficiency with a huge market share. There is a moderately high barrier for the new entrants as they differentiate themselves from Starbuck’s product quality, its prime real estate locations, and its store ecosystem ‘experience’.
The incumbent firms like Starbucks have a larger scale and scope, yielding them a learning curve advantage and favorable access to raw material with the relationship they build with their suppliers. The expected retaliation from well-established companies for brand equity, resources, prime real estate locations and price competition are moderately high, which creates a moderate barrier to entry.
Threat of Substitutes: High
There are many reasonable substitute beverages to coffee, which are mainly tea, fruit juices, water, soda’s, energy drinks etc. Bars and Pubs with non/alcoholic beverages could also substitute for the social experience of Starbucks
Consumers could also make their own home produced coffee with household premium coffee makers at a fraction of the cost for buying from premium coffee retailers like Starbucks.
There are no switching costs for the consumers for switching to substitutes, which makes the threat high.
But its important to note that industry leaders like Starbucks are currently trying to counter this threat by selling coffee makers, premium coffee packs in grocery stores but this threat still puts pressure their the margins.
Bargaining Power of Buyers: Moderate to Low Pressure
There are many different buyers in this industry and no single buyer can demand price concession.
It offers vertically differentiated products with a diverse consumer base, which make relatively low volume purchases, which erodes the buyer’s power.
Even though there are no switching costs with high availability of substitute products, industry leaders like Starbucks prices its product mix in relation to rivals stores with prevailing market price elasticity and competitive premium pricing.
Consumers have a moderate sensitivity in premium coffee retailing as they pay a premium for higher quality products but are watchful of excessive premium in relation product quality.
Bargaining Power of Suppliers: Low to Moderate Pressure
The main inputs into the value chain of Starbucks is coffee beans and premium Arabica coffee grown in select regions which are standard inputs, which makes the cost of switching between substitute suppliers, moderately low. Strategic Analysis Of Starbucks Corporation Certified coffee under its coffee and farmer equity (C.A.F.E) program, which gives its suppliers a fair partnership status, which yields them some moderately, low power.7
The suppliers in the industry also pose a low threat of competing against Starbucks by forward vertical integration, which lowers their power.
Intensity of Competitive Rivalry: High to Moderate
The industry has a monopolistic competition, with Starbucks having the largest markets share and its closest competitors also having a significant market share, creating significant pressure on Starbucks. Consumers do have any cost of switching to other competitors, which crates high intensity in rivalry.
But its important to note that Starbucks maintain some competitive advantage as it differentiates its products with premium products and services, which cause a moderate level of intensity in competition.
The industry is mature and growth rate has been moderately low which cause the intensity of competition among the companies to be moderately high due to all of them seeking to increase market shaper from established firms like Starbucks.
This industry does not have over capacity currently and all these factors contribute to the intensity among rivals to be moderately high.
Looking at the Porters five forces analysis, we can get an aggregate industry analysis that the strength of forces and the profitability in the retail coffee and snacks industry are Moderate
http://scholar.harvard.edu/files/nithingeereddy/files/starbucks_case_analysis.pdf Cost structure
Coffee prices fluctuate heavily from year to year. However, coffee prices do not fluctuate proportionally in each stage of the marketing chain. Consumer prices for example fluctuate less than prices of green coffee on the world market. The degree of fluctuation depends strongly on the way prices are determined. When farmers know in which stage of the production and marketing chain their prices are the most resistant to pressure by buyers and sellers, they can select the most profitable position to increase their market power. Section two takes a look at how prices are influenced and by which factors they are influenced. In section three a closer look is taken at the instability in receipts from coffee exports, caused by fluctuations in prices. This is followed in section four by an exposition about the influence of international commodity agreements on world coffee prices. In this section a short history is presented of the International Coffee Agreements (ICA’s). Section five describes how the margin on coffee is distributed over each stage in the marketing chain. The final section of this chapter presents some conclusions about the pricing in the world coffee market.
4.2 Influences on coffee prices
When looking at the price pattern of coffee, one notices that prices are not stable. Price instability occurs in the long run, but also short term prices may change. This section takes a closer look at how coffee prices are determined. Determination of prices depends in the first place on the type of prices. World coffee prices are largely set on the futures and forward coffee markets. The quantity traded on these markets is much larger than actual trade in coffee. Prices are determined on the world market by means of speculation and arbitrage. Since coffee prices are influenced by speculation, pricing depends strongly on expectations about future supply and demand. Local coffee prices may differ between several coffee producing countries. According to De Rijk (1980), prices paid to Indonesian exporters at a given world price depend on the quality of the coffee and regularity and reliability of the quality. Other influences on local prices, according to De Rijk, consist of costs, taxes, information on prices and reliability of contracts. For some decades now the coffee market is showing a structural overproduction. This overproduction is one of the causes of the weak position of coffee farmers. Figure 3.3 shows that exporting countries possess large stocks. These stocks are mostly set up in abundant years and are used in years of general shortage. Shortages in the supply of coffee are often caused by crop failures through natural incidents.
The price of coffee is therefore susceptible to frost and drought, which are two of the leading factors in natural causes. Stocks can be kept by local farmers but more often these stocks are kept by large trading companies, which act as arbitrageurs. Trading companies buy at low prices when supply is abundant and they keep it in stock till prices rise. This provides some extra gains to trading companies, besides the normal margins on trading. Local farmers often do not have the financial resources and storage capacity to keep these stocks themselves. Therefore, they have to sell their coffee to exporters at harvest time against low prices. Farmers could have earned higher prices if they had kept their coffee in stock till the market improved. World prices, farmer prices and consumer prices are correlated with each other. Because stocks appear at different stages in the marketing chain, these prices do not fluctuate proportionally. This is shown in figure 4.1. Mostly these price shocks are taken by exporters’ stocks. As has been mentioned before, exporters often possess more financial resources for storage than local farmers. Also consumer prices fluctuate less than world coffee prices. This is explained by the price setting behaviour of coffee roasters. When world prices go down, consumer prices decrease only fractionally. In case of increasing world prices, consumer prices increase to a larger extent than in case of a price decrease.
Besides correlation between prices at different stages of the marketing chain, different types of coffee are also related in pricing. Vogelvang, in his 1992 study, tested some hypotheses concerning the long-run relationships between spot prices of the four main types of coffee. Because coffee types are related to each other, some specific factors concerning the coffee market will be relevant here. These factors are the rate of substitution of coffee types, changes in total world supply or demand, and the existence of an International Coffee Agreement. Besides these specific factors, factors that influence all prices, such as world inflation, interest rates and expectations about economic variables, explain relatedness in prices. Vogelvang computes the following long run equilibrium equations:
pcm = 0.91 + pua
pom = 11.39 + pua
prob = -21.47 + pua
where prices are measured in US cents per pound. In these equations cm applies to Colombian Milds, om to Other Milds, rob to Robusta and ua to Unwashed Arabicas (Brazilian). The equations show that prices of Colombian Milds, Other Milds and Robusta are linearly related to price behaviour of Brazilian coffee. In his study, Vogelvang concludes that all the coffee prices move together in the long run. Absolute prices therefore deviate with a certain constant. The equations imply that in the long run Colombian and Other Milds are priced 0.91 cents respectively 11.39 cents per pound higher as Brazilian coffee. The Robusta price of one pound of Robusta is 21.47 cents lower in the long run than the price of Brazilian. Hypotheses concerning a relationship between Robustas and Other Milds are not statistically rejected, but results from this study can not prove a strong relation between low quality coffee like Robusta and high quality coffee like Other Milds.
4.3 Instability in export earnings
It has been mentioned previously that the proportion of primary products in total exports of developing countries is high. Prices of primary products fluctuate rather strong. Therefore, these fluctuations may have a large impact on export earnings, imports, investment, employment and government expenditures. Instabilities like these may disrupt the economy of these countries (MacBean & Nguyen, 1987, p.88; Södersten, 1980, p.249-255). Price instability and earnings fluctuations are interrelated. Yet, they do not fluctuate proportionally. This depends on the values of the price elasticity of demand, the income elasticity of demand and the price elasticity of supply. The price elasticity of demand measures responsiveness of coffee demand to prices. So, it represents the ratio of percentage change in the quantity demanded to percentage change in price. Similarly, the ratio of percentage change in the quantity supplied to percentage change in price is called the price elasticity of supply. The income elasticity shows how responsive quantity demanded is to a change in income Suppose price elasticity of demand is (-1). Some coffee farmers decide to increase their production. This implies that world coffee supply increases. In a competitive market, coffee prices will decrease and therefore, demand for coffee will increase. Besides the fact that farmers will receive less payment for each bag of coffee, demand and total quantity exported increases.
Therefore, the fall in prices has been exactly offset by higher sales, and the farmers’ income will remain unchanged. This conclusion only applies to the world coffee market in its entirety. The outcome may be all different for individual countries and individual farmers. Mostly one or a few farmers are responsible for an increase in supply. These farmers must be able to produce at low costs, since prices will drop below the initial level. Other coffee farmers may also face a lower price per unit. Therefore some marginal farmers may go out of production, causing prices to return to the long term level. Remaining farmers, who did not change production, have to sell the same output against lower short term prices. Because of this, their total returns will be lower and with the same level of costs, their profits will decrease temporarily. The effects of shifts in supply would be larger if there were economies of scale in coffee production. With economies of scale farmers are stimulated to increase their production, in attempt to reduce their average costs. So, farmers who increase their production earn higher profits at the expense of farmers with a fixed level of production. However, increases in scale are not possible unlimitedly. Mostly this is restricted by the scarcity of fertile land.
Price elasticity of demand
In general, price elasticities of demand are low when the product has a low income elasticity, has little or no substitutes and forms a small part of the consumer’s budget. The average price elasticity of demand in industrialised countries with respect to retail prices is, according to estimates by the UN Food and Agriculture Organisation (FAO), about (-0.34). This implies that a 1% price increase (decrease) is accompanied by a decrease (increase) in consumption by 0.34%. Estimates with respect to
import prices amount to (-0.2). Other studies have indicated an elasticity of between (-0.2) and (-0.3) in high income countries and of between (-0.4) and (-0.5) in lower income countries (EIU, 1995, p.17).
Competitive Forces that impact competition (Porter Model)
3.1 Competition within the Coffee Shop Industry
20,000 stores with annual revenue of ~ $11 billion
Highly concentrated at top and fragmented at bottom – Starbucks ~ 75% of sales Major companies: Starbucks, Caribou Coffee, Coffee Bean and Tea Leaf, Diedrich (Gloria Jean’s), Peet’s Coffee Competitors can also be found in other industries (convenience stores, gas stations, quick service, fast food restaurants, gourmet food shops, donut shops, filter ~ / specialty coffee machines for home use) e.g. Dunkin’ Donuts and McDonalds Competition through special offers (new tastes), outstanding service/ environment (internet, music, comfortable seating areas, short waiting queues), loyalty programs (bonus cards ensuring frequency of visits) and for premium locations (retail centers, university campuses, etc.)
Conclusion – Competition within the Coffee Shop Industry
Strong competition within the industry for new customers, premium locations, etc. but overall the industry is saturated, settled and stable which allows almost all of the competitors to yield very good margins (40 to 60 percent)
3.2 Substitute Products
Competition with other drinks that are not the main focus of by coffee shops: Soda, Juice, Water, Beer, Sports Drinks
Competition with other products, people are spending their money on: Ice Cream, Cigarettes, Sweets
Consumers have limited discretionary budget to spend on consumer goods, such as cigarettes, beer and also coffee; coffee shops are therefore fighting for a fraction of this budget
Conclusion – Substitutes in the Coffee Industry
Very b power of substitute products as especially young people might prefer other products, such as beer, cigarettes or soda
3.3 Barriers to Entry
Rather low entry barriers: easy to open a single small café Rent a place, remodel, install the equipment, get license as needed However there are high entry barriers for the specialty level or big league/chain players High up-front investment needed to grow significantly (distribution system: shops, equipment, premium locations; marketing: creation of brand awareness & brand recognition, customer retention) Strong brand recognition of major players, especially Starbucks Partnerships with large, international companies also serve as potential entry barrier for new competitors – Starbucks with Pepsi/ Jim Beam/ Dryer’s Grand Ice Cream/ Barnes & Noble or Caribou Coffee with Apple (See Exhibit 2). Economies of scale (purchase advantages; centralized HR and Marketing) realized by big players, especially Starbucks è cost disadvantage for new entrants
Conclusion – Barriers to Entry in the Coffee Industry
Small barriers to entry for small regional chains / cafés, but their expansion is relatively slow due to the increasing speed of the expansion of the major players High barriers to entry into the industry for big players due to high industry concentration on top, huge brand recognition of major brands and high up-front investments are needed
3.4 Power of Suppliers
Volatile Raw Material Costs:
Particular dependence on supply of higher-priced Arabic beans (premium coffee) – as imported mostly from developing countries, price varies along with the economical and political situation of the export country Dairy products, whose retail prices vary a lot, used for specialty drinks Coffee Shop Chains have contracts securing price stability
For most coffee-exporting countries (over 60 ) that is their only “source of cash” Higher world market demand and higher prices for differentiated (Gourmet and specialty coffees) and sustainable coffee (organic, fair trade, eco-friendly or shade grown) than for coffee commodity: Farmers not agile enough or don’t have the means to switch production Companies are helping communities to make the change (train them, purchase at fair trade prices and provide technical assistance)
Conclusion – Power of Suppliers in the Coffee Industry
Very limited power of suppliers as they depend on producer’s help and sell a commodity.
3.5 Power of Customers
High dependency of coffee shop chains on frequency of customer purchases Most customers appreciate the nice atmosphere in the coffee shops Preferences of customers are very likely to switch as they might get bored with / tired of the same flavor (relatively low brand loyalty) Shopping behavior is very likely to be influenced by budget constraints, weather conditions or health concerns in the general public Interested in continuous product innovation or seasonal specialties Essential for success – word of mouth and frequency of purchases
Conclusion – Power of Customers in the Coffee Industry
Very b power of customers as coffee shops depend on word of mouth and customer retention Furthermore a customer’s opinion, preferences and shopping habits can be influenced easily which creates a big threat for the companies.
Markets are characterised by the interaction of buyers and sellers. Generally, economic literature distinguishes two ways of interpreting the ‘market’ concept. These interpretations concern the concrete and abstract concept of markets. The first deals with tangible markets. The latter concerns interaction of supply and demand, without the need of immediately supplying the products or having them in the market place. Section two of this chapter presents four main types of market structures. The type of market structure largely determines the relationship between buyers and sellers. Therefore, it also influences pricing of the product and the distribution of income between economic agents throughout the production and marketing chain. Section three deals with the reasons why markets might diverge from a situation of perfect competition. This situation of imperfect competition is caused by the presence of barriers to entry. This section presents six sources causing these barriers as mentioned by Michael Porter (1980). Finally, section four draws some conclusions.
2.2 Types of market structure
In the introduction of this chapter it was mentioned that the ‘market’ concept has two different interpretations. Next, this study operates the abstract concept of markets, when dealing with market structures. Economic literature distinguishes four main types of markets. These markets are divided into perfectly competitive markets, monopoly markets, oligopolistic markets and markets with monopolistic competition. Each stage in the production and marketing chain considered in next chapters, may be characterised by a different type of market. Before examining the coffee market, this section will deal briefly with each type of market.
When economists talk about a competitive market, they mean a market with the following four characteristics: First, the market consists of many small buyers and sellers, where no individual buyer or seller is large enough to influence the market price of their product. Second, the product is standardised, which implies that it is a homogeneous product. Third, there are no entry and exit barriers. Fourth, there is complete and perfect knowledge about technology and market prices (Martin, 1993, p.15). In competitive markets suppliers can sell their products only with short term economic profits. In the long run this situation cannot persist. When suppliers earn profits, i.e. their price exceeds their average costs, new suppliers enter the business and established suppliers increase their output in the long run.
On the other hand there are markets which are dominated by one supplier. This market structure is called a monopoly. Two things distinguish a monopoly from a competitive market. First, there is only one single supplier that supplies the market. Secondly, entry by other potential suppliers is blockaded. The first characteristic ensures that the monopolist faces no actual competition. Because of this, the monopolist may choose to supply at any point on the market demand curve. To earn the largest possible profit, the monopolist will choose the output that makes his marginal costs equal to his marginal revenue. His output decision will determine the price of the product, which makes him a price setter. The second characteristic implies that the monopolist faces no potential competition. To restrict other suppliers from entering the market there have to be some barriers to entry (Martin, 1993, p.23-24). These barriers are discussed in more detail in the next section.
In a competitive market, each supplier is so small that it cannot affect the price. When the supplier raises its price above equilibrium price, he will loose his sales to other suppliers or new entry is provoked. At the other extreme, the monopolist has no rivals to worry about. The monopolist can raise his price without provoking new entry. Between these two extreme cases there is another type of market. Martin (1993, p.110) characterises this type of market by the presence of a few large suppliers which dominate the industry. These suppliers recognise their mutual interdependence and therefore cannot act as a monopolist. This third type of market is called an oligopolistic market. So, under oligopoly there is intense rivalry. Yet, barriers to entry are present which allow for long term profit (Maddala & Miller, 1989, p.375).
An essential characteristic of this fourth type of market is product differentiation. Maddala & Miller characterise this market “by a large number of suppliers, each of which has a little market power because it offers a differentiated product. Yet all the suppliers are in competition because their products are close substitutes.” So, “there are no barriers to entry under monopolistic competition and, hence, there are no economic profits in the long run” (Maddala & Miller, 1989, p.375).
Differences in market structure lead to differences in marketpower. Therefore, within the framework of this study, it is important to picture these differences in market structure among subsequent stages. In chapter five it is shown that these differences can be very large for some of the stages in the production and marketing chain of coffee.